Xonics Photochemical, Inc., Matter of

• Decision Date: 08 March 1988
• Docket Number: No. 87-2143,87-2143
• Citation: 841 F.2d 198,17 BCD 606
• Parties: 18 Collier Bankr.Cas.2d 711, 17 Bankr.Ct.Dec. 606, Bankr. L. Rep. P 72,211 In the Matter of XONICS PHOTOCHEMICAL, INC., Debtor. Appeal of MITSUI AND COMPANY (U.S.A.), INC.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 198

841 F.2d 198

18 Collier Bankr.Cas.2d 711, 17 Bankr.Ct.Dec. 606,

Bankr. L. Rep. P 72,211

In the Matter of XONICS PHOTOCHEMICAL, INC., Debtor Appeal of MITSUI AND COMPANY (U.S.A.), INC.

No. 87-2143.

United States Court of Appeals Seventh Circuit.

Argued Jan. 6, 1988.

Decided March 8, 1988.

Thomas D. Goldberg, Hughes Hubbard & Reed, Washington, D.C., for appellant.

Erick S. Rein, Schwartz, Cooper, Kolb & Gaynor, Chtd., Chicago, Ill., for appellee.

Before POSNER, COFFEY and EASTERBROOK, Circuit Judges.

POSNER, Circuit Judge.

This bankruptcy case presents interesting questions concerning the status in bankruptcy of contingent liabilities and interaffiliate obligations. For background see Comment, Avoidability of Intercorporate Guarantees Under Sections 548(a)(2) and 544(b) of the Bankruptcy Code, 64 N.C.L.Rev. 1099 (1986). Xonics, Inc., now in Chapter 11 bankruptcy, has several wholly owned subsidiaries that are engaged in making medical equipment. The largest is Xonics Medical Systems, Inc.; one of the smallest is Xonics Photochemical, Inc., the debtor in the proceeding before us. In 1982 and 1983, a time of prosperity for the Xonics family, Xonics Medical Systems borrowed some $15 to $20 million from a bank, on a $25 million credit line. Xonics, Inc., the parent, caused Xonics Photochemical, Inc. (along with the other subsidiaries) to guarantee the loan; at the time Xonics Photochemical had gross assets of some $2.6 million and net assets of $1.7 million. Xonics, Inc. also caused Xonics Photochemical to become a co-maker with Xonics Medical Systems of a note to secure an additional loan of $3 million.

Shortly after these transactions, Mitsui & Co. (U.S.A.), Inc., a supplier to Xonics Photochemical, shipped it some chemicals, and invoiced it for the purchase price, which was (approximately) $124,000. Xonics Photochemical paid the invoice with two checks that cleared in January 1984. Fewer than 90 days later, Xonics Photochemical was in bankruptcy. Xonics Medical Systems had defaulted on its bank loan, triggering the guarantees of its affiliates. The total assets of the Xonics family--all of which were pledged to the creditors of each member through guarantees similar to the one Xonics Photochemical had signed--were short of the total liabilities by many millions of dollars; so all the subsidiaries, as well as the parent, found themselves in Chapter 11.

Xonics Photochemical, as debtor in possession (no trustee in bankruptcy had been appointed), brought an adversary proceeding against Mitsui to set aside the two payments as preferences voidable under 11 U.S.C. Sec. 547(b). This provision makes transactions voidable by the trustee, but 11 U.S.C. Sec. 1107(a) gives the debtor in possession the powers of a trustee. The dispositive issue was whether Xonics Photochemical had been insolvent when the payments to Mitsui were made; that is, did the fair value of its liabilities exceed the fair value of its assets (11 U.S.C. Sec. 101(31)(A))? If so, the payments were indeed voidable preferences, see 11 U.S.C. Sec. 547(b)(3), since the other conditions in section 547(b) had been met. The bankruptcy judge and the district judge thought Xonics Photochemical had been insolvent then; Mitsui disagrees and has appealed.

The startling feature of the case is the parties' apparent assent to the proposition that if the loan guarantee and the note that Xonics Photochemical had co-signed were valid obligations, Xonics Photochemical was insolvent as of the date the obligations were assumed, on the theory that they created liabilities greater than the company's net assets (much greater: $28 million in liabilities versus less than $2 million in net assets). The proposition is absurd; it would mean that every individual or firm that had contingent liabilities greater than his or its net assets was insolvent--something no one believes. Every firm that is being sued or that may be sued, every individual who has signed an accommodation note, every bank that has issued a letter of credit, has a contingent liability. Such liabilities are occasionally listed on the firm's balance sheet, for example by earmarking a portion of surplus for contingent liabilities. (They are supposed to be listed "if the future event is likely to occur and if its amount can be reasonably estimated." Nikolai et al., Intermediate Accounting 611 (3d ed. 1985) (emphasis in original).) More often they are listed in a footnote, thus leaving the firm's stated net worth undisturbed. Often they are not listed at all, when they are remote or when they are too small to affect net worth substantially. On the proper accounting treatment of contingent liabilities see id. at 610-14; Faris, Accounting for Lawyers 362-64 (3d ed. 1975); Williams, Stanga & Holder, Intermediate Accounting 609-17 (1984); Meigs, Mosich & Johnson, Accounting: The Basis for Business Decisions 288 (3d ed. 1972); Financial Accounting Standards Board, FASB Statement of Standards No. 5 (1975).

There is a compelling reason not to value contingent liabilities on the balance sheet at their face amounts, even if that would be possible to do because the liability, despite being contingent, is for a specified amount (that is, even if there is no uncertainty about what the firm will owe if the contingency materializes). By definition, a contingent liability is not certain--and often is highly unlikely--ever to become an actual liability. To value the contingent liability it is necessary to discount it by the probability that the contingency will occur and the liability become real. Suppose that on the date the obligations were assumed there was a 1 percent chance that Xonics Photochemical would ever be called on to yield up its assets to creditors of Xonics Medical Systems (or other members of the Xonics family, since the system of guarantees had the effect of pooling their assets for the benefit of creditors of any member). Then the true measure of the liability created by these obligations on the date they were assumed would not be $28 million; it would be a paltry $17,000. For at worst Xonics Photochemical would have to yield up all of its assets (net of other liabilities), that is, $1.7 million, and the probability of this outcome is by assumption only 1 percent (we are ignoring intermediate possibilities--e.g., that Xonics Photochemical would be forced to cough up $1 million rather than $1.7 million). Discounted, the obligations would not make Xonics insolvent, and section 547(b) would not come into play unless events occurring between the assumption of the obligations in 1982 and 1983 and the bankruptcy in 1984 had altered the picture. We add that Xonics Photochemical did not in fact list these obligations as liabilities on its balance sheet.

The principle just outlined has long been recognized in cases dealing with the question whether a firm is insolvent within the meaning of the Bankruptcy Code (and this is such a case). It makes no difference whether the firm has a contingent asset or a contingent liability; the asset or liability must be reduced to its present, or expected, value before a determination can be made whether the firm's assets exceed its liabilities. See, e.g., Syracuse Engineering Co. v. Haight, 97 F.2d 573, 576 (2d Cir.1938) (L. Hand, J.); In re Ollag Construction Equipment Corp., 578 F.2d 904, 909 (2d Cir.1978); In re Fulghum Construction Co., 7 B.R. 629, 632-33 (Bankr.M.D.Tenn.1980), aff'd, 14 B.R. 293 (M.D.Tenn.1981); In re Hemphill, 18 B.R. 38, 48-49 (Bankr.S.D.Iowa 1982). The criticism of this position in the student Comment cited earlier, 64 N.C.L.Rev. at 1118-19, is perfunctory and unpersuasive.

Occasionally one finds the flat statement that "contingent or inchoate claims of the bankrupt are not included as part of the bankrupt's property." Allegaert v. Chemical Bank, 418 F.Supp. 690, 692 (E.D.N.Y.1976). This is the equally untenable opposite extreme from valuing them at their face amount. But the quoted language appears to be loose; what these cases actually mean is that if, but for a contingent claim unlikely to yield any cash in the near future, the firm would be deemed insolvent, the existence of a faint hope--cold comfort for creditors waiting to be paid--will not save it from bankruptcy. See Penn v. Grant, 244 F.2d 309 (9th Cir.1957) (per curiam); In re Bichel Optical Laboratories, Inc., 299 F.Supp. 545 (D.Minn.1969). No more should the existence of remote contingencies, which do not seriously endanger the firm's ability to pay its debts, be deemed to make an otherwise solvent firm bankrupt. See In re Waters, 8 B.R. 163, 166 (Bankr.N.D.Ga.1981).

We have gone into this non-issue at such length only to avoid creating the unsettling impression that contingent liabilities must for purposes of determining solvency be treated as definite liabilities even though the contingency has not occurred. Mitsui has chosen not to make an issue of the contingent nature of the guarantee and of the co-signature of the note; maybe Xonics Medical Systems was really insolvent by the time Mitsui received the payments in issue from Xonics Photochemical, so that the contingent liability was no longer contingent. The only argument Mitsui makes against the finding that the payments to it were voidable preferences is that Xonics Photochemical was not insolvent when they were made because the transactions between it and its affiliates were (1) void under state law (the parties agree that the applicable state law is that of Illinois), or (2) voidable as fraudulent conveyances. If either contention is correct, the transactions created no liabilities on the part of Xonics Photochemical and therefore could not have made it insolvent, whatever the plight of Xonics Medical Systems; hence section 547(b) would not be triggered.

1. When a parent causes one of its subsidiaries to guarantee another's (or the parent's own) debts, there is an obvious danger--one indeed that has...